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Why more ECB QE won’t kill this euro rally

he central bank only has a ‘pea shooter’ left, HSBC analyst says

ReutersECB President Mario Draghi is running out of options to weaken the shared currency, strategists say.

All the stars are aligning for a weaker euro: Deflation is knocking on the eurozone’s door, there’s been a string of lackluster economic data and the European Central Bank is increasingly expected to launch more QE.

Yet, the shared currency is having none of it. Over the last three months, the euroEURUSD, -0.2108% has risen nearly 5% against the dollar to trade around $1.1441 and tacked on 5.8% against the pound EURGBP, -0.1902% to £0.7425.

This comes even as several analysts earlier in the year proclaimed 2015 would be the year when the euro slumped to parity with the dollar for the first time since 2002, following an aggressive round of ECB easing and expectations of a Federal Reserve rate hike.

But according to some currency strategists, that the euro has climbed instead of weakened isn’t a surprise.

“If the euro can’t go down on the Volkswagen story, and the euro can’t go down on the Greek story, it should be telling you something,” said David Bloom, global head of FX research at HSBC.

“The Fed is not as hawkish as people thought [it] would be and the ECB is not as dovish as people think [it] should be,” he said. “The monetary-policy differential is actually closing and that’s favoring the euro.”

HSBC in late September raised its 2015 year-end forecast on the shared currency to $1.14 from $1.05 and lifted its year-end 2016 forecast for the euro to $1.20 from $1.10.

The euro hit a 12-year low around $1.05 in March, weighed down by the launch of the ECB’s €1.1 trillion ($1.26 trillion) quantitative-easing program and expectations a U.S. rate hike was imminent. In other words, a sharp divergence in monetary policy that usually propels the dollar sharply higher, while hammering down the euro.

Markets still see this divergence playing out in the months ahead. Investors expect the ECB to announce further easing measures by year-end and anticipate the Federal Reserve will hike interest rates in December or early 2016.

However, Bloom said there’s little chance this will serve to weaken the euro, as these moves have already been largely priced in and the ECB is running out of large-scale easing options.

“I think [ECB President Mario Draghi] used his big bazooka and he now looks in his cupboard and he’s got a small pea shooter,” the HSBC strategists said.

“The ECB artificially suppressed the currency through QE, but that’s coming to an end... They may do something or make QE open ended, but they will struggle to be ultra dovish," he added. “We need some big stuff here for the euro to move. Not only do we not see that happening, we also think it’s not possible. There are some rules and regulations they set themselves that make it very difficult.”

Simon Smith, chief economist at FxPro, said he doesn’t see how more ECB easing would push the euro dramatically lower like it did in March.

“In the early days of QE, it impacted currencies massively. The dollar was going lower and there was a big bang for your buck with QE,” he said.

“But for the eurozone, because they came so late to the party, there’s a different relationship between QE and the currency. It’s pretty weak. It’s simply because of lower, diminishing returns. You’ll get less for the more you do something,” he added.

Smith also noted that the key ECB interest rate is already close to zero, which has helped push German two-year bund rates substantially into negative.

“It’s difficult to squeeze those lower,” he said. “Already in some countries they are struggling to find bonds to buy. It would have to be even more unconventional means by which they undertake QE.”

Low interest rates usually are followed by lower exchanges rates, because it decreases the demand for the currency.

However, not everyone is bullish about the outlook for the euro. Goldman Sachs has stuck to its forecast that the shared currency will fall to 95 cents next year. Morgan Stanley, in its latest FX outlook, saw the euro at parity with the dollar in fourth quarter of 2016.

At Société Générale they are currently reviewing their forecast of euro-dollar parity in the first quarter of next year on the back of delayed rate-hike expectations in the U.S. However, Vincent Chaigneau, head of FX at the French bank, explained the euro will likely struggle to break above its August peak of $1.1715.

“As the euro rises, speculation about further ECB QE and/or a deposit rate cut will be rising too, which should cap the euro. So I don’t think that’ll run very far, but for now EUR/USD may be heading toward those resistance levels,” he said.